27th October, weekly thoughts

Coming up this week, we've got a few important events - namely the FOMC statement this Wednesday, but also other events such as EZ CPI, RBNZ OCR, Chinese PMIs and the BoJ. This week should be pivotal, and will likely set the tone for the rest of the year, specifically in G10 rates and FX.

Regarding the FOMC, we will see the end to the QE program with another 15bn taper. Discussion around considerable time might arise, however given current market pricing (via FF futures and EDs) it is expected that we have another 11 months until the 1st rate hike.  

MS M1KE

The problem is that the US economy is getting to the point where a rate hike is sensible, no matter how we put it, the recent risks that have developed in the past few months will likely (and hopefully) reside. Whether they be risks from China or Europe, they don't seem enough to really put of US hikes.

However, there is no escaping the fact that Yellen really doesn't want to hike, and there have been a few timely excuses that she will use to push back expectations. Namely weakness in oil prices leading to a drop in inflation expectations, however long term expectations have dropped only marginally. The ECB apparently loves the 5y5y measure, yet I am sure the Fed will forget to mention that long term inflation expectations are stable (ish), but will focus on shorter inflation swaps.

5y5y inflation expectations

Using a Taylor rule estimate for the US fed funds, we can see that even if we were to hike on we Wednesday its still dovish... But I know there are many flaws with a Taylor rule estimate, but I'm just using it to illustrate a point that even if Yellen wants to put off hikes, there will come a time in the not-too-distant future that she will be forced.

Mankiw's estimate for Taylor rule

It is worth bearing in mind the next couple of charts... 

EURUSD against 2 year swap spread

 The EUR still appears cheap to rates, and on the chance we see Yellen make some excuses, the USD is vulnerable to a short term correction towards 1.3000, that is where the pain trade is in the FX markets, and it seems more and more likely.

US 2 year govt bond yield

After the other weeks crazy rates move, US 2's have stabilised, yet are way below where they were, I prefer paying US rates, and shorting the USD, it offers a better risk:reward, and is hedged somewhat into FOMC.

On to the RBNZ and the NZD now... the 90 day bank bill futures see the next hike about 6 months away, however I would be more unsure about that. With NZ's Terms of trade plummeting (milk, innit) and a further slowing down in China, the RBNZ will be hesitant to hike further, and may even be regretting the recent 100bp move given the last CPI print. Either way, hikes are off the table, and it's very likely we don't see another RBNZ hike before the Fed.

90 day bank bill futures curve, now / 1m ago /3mago

 We can see the drop in rate expectations from the above curve chart for the 90-day bank bill, while not huge, its certainly not insignificant.

NZD vs carry/vol

Here we can see the impact clearly with Carry/vol (1y1y / FX vol). Furthermore, given risks to short run outlooks we should see a pick up in vol further, and combining this with lower NZD rates, the NZD is likely to under perform.

Next up... Brazil, and we have some elections! now I know very little about these, as I haven't been following. But Dilma Rousseff is probably going to win given recent pollings, and options markets have moved accordingly with a sizeable mark up in vols, and 1 weeks still around 40 (as of friday)

USDBRL 1 week ATM vol

The vol surface is interesting too, with very little skew between puts and calls, which is quite odd around risk events!

BRL vol surface

USDBRL

$BRL had gone from being the best performing ccy (carry adjusted) for the year just two months ago, to barely even flat. The sharp sell-off has led some banks to suggest buying, given the "oversold" nature of the BRL currently and the high implied yield from NDFs (just shy of 10%)

However, BRL and BRL options are outside of my investable universe, so I'm just watching, but it's interesting nonetheless.

In $RUB, we are starting to get into that area where I'm going to start looking at the RUB in a constructive way... Implied have spiked higher with 3m ATMs at 15, with 25d riskies at 5. With the RUB firmly in the intervention zone for the Central bank and with plenty of firepower I would expect the large sell-off to start to slow down. 

USDRUB and 2 year swaps top pane, vol and rr's in bottom

 The RUB is incredibly vulnerable and I'm certain weakness in oil prices are not helping, this being said, I am looking to buy (via options) through till year end. (short 45 calls, long 40 puts - taking advantage of skew, whilst long RUB)

RUB 1y xccy basis

Looking at the basis, the $ liquidity problems are still firmly about, however it is starting to come off a little which should take away from the local demand for $'s

Anyway, just some quick thoughts. Have a good week.